April 9, 2007 issue - In recent weeks, you've heard plenty about the sleazy side of the subprime mortgage business. Rising numbers of borrowers are losing their homes after being lured into high-cost mortgages they couldn't afford. But there's another piece of the painful subprime story that hasn't hit the headlines yet: costly -- sometimes abusive -- subprime credit cards. They're bleeding millions of borrowers who didn't know what they were getting into.
Subprime borrowers tend to have credit scores under 660. They've missed or defaulted on payments in the past and already carry a lot of debt. But even prime borrowers, with credit scores solidly in the 700s, can slide into subprime status if they're late on a couple of payments.
Subprimes come in two types: Cards that are crazily costly to begin with and cards that look good but hide big traps. You know about traps if you've paid some bills late and are now being charged with interest at 30 percent. In general, here's how the business works:
The bottom-feeding cards -- for people with damaged credit -- offer you a decent interest rate on credit lines "up to" $3,000. When the card arrives, however, your line might be only $250. And then come the fees! "Program" fees. Account set-up fees. Participation fees. Annual fees. They're charged to your tiny credit line, leaving you almost nothing to spend.
Take the First Premier Bank Gold Card, at 9.9 percent interest with a $250 line. After charging upfront fees, however, you start out with a debt of $178 and just $72 extra to spend. Or the First Bank of Delaware's Continental Finance card, at 19.92 percent interest, where a $300 credit limit shrinks to $53 after upfront fees. When you start using either card, you'll be charged $6 or $10 a month. One little purchase puts you over the limit. That unleashes a $25 or $30 over-limit fee, plus another $25 or $30 if you pay late. As a further penalty, First Premier can double your interest rate. You could wind up owing thousands of dollars in compounding fees.
First Bank of Delaware didn't respond to questions. Miles Beacom, First Premier Bankcard's CEO, says the cost of these cards reflects how risky the borrower is. But if someone can't afford a small payment, why is he getting more credit at all? These cards target people of modest means, says credit expert Robert Manning, adviser to the film "In Debt We Trust," to be released this month. At some point, aggressive lending turns into abuse.
Two better-known card issuers with a big subprime business are Capital One and HSBC's Orchard Bank. They charge lower upfront fees than other cards do. But if you fall behind, it's tough. Cap One's penalty rate is currently 28.15 percent. Orchard Bank doesn't disclose its penalty rate online and wouldn't tell me what it is (that didn't engender confidence!). Cap One has a reputation for issuing multiple cards to people who bump up against their credit limits. That gives them two cards, with two low limits, to overspend. John Finneran, Cap One's general counsel, says that customers choose to have multiple cards for various reasons and have the option of combining them into one.
Lenders have figured out many ways of extracting fees. There's "universal default," where a late payment on one card can trigger high penalty rates on every card you own. There's the "endless late fee," where your payments never catch up with the new penalties you're charged. (Banks don't cancel your cards, as they did in the old days; they just keep charging until you break.) There's "two-cycle billing" -- too complicated to explain here, but which amounts to charging interest on balances that you've already paid. And "retroactive price hikes," where banks impose higher rates on old balances as well as new ones. "What other business can get away with raising the price of something you already purchased?" says Travis Plunkett of the Consumer Federation of America.
These practices startle consumers who think such high fees and interest rates must be against the law. But the Supreme Court effectively deregulated credit card rates 30 years ago, and 10 years ago it deregulated the size of the fees a bank could charge. Prior to fee deregulation, late fees hovered between $13 and $15, says Robert McKinley of CardWeb.com, which tracks the business. Now they run from $30 to $40. "It's out of control," he says. "Banks know they've pushed this too far."
So far, they've gotten away with it. Congress ignored it and the regulators slept. Occasional court cases pop up. Last year, New York State fined Cross Country Bank (now the Applied Card Bank) $9 million for various deceptive practices. Applied's attorney denies the allegations. Capital One recently settled a class-action lawsuit, also alleging deceptive acts. (To read what consumers say about these and other cards, go to Consumeraffairs.com).
This year, however, the new Congress started holding hearings. Suddenly Citi dropped universal default and JPMorgan Chase ended two-cycle billing. But those are just gestures. Without fee caps or usury laws, we're in the bankers' hands.
Reporter Associate: Temma Ehrenfeld
This story ran on Newsweek on April 9, 2007.